Economists were seduced by physics because it made their claims seem more scientific. Their belief was in the concept of equilibrium, in which it would be impossible to profit from trading around a circle of goods or a circle of currencies without actually producing anything. Of course, that is possible, and that did happen, and that’s because you’re never really at equilibrium.

Published on Jun 3, 2013

Transcript after the jump

So I got pulled into economics in 2007 because of the 2008 economic crisis. Mike Brown who had been the first CFO of Microsoft, Chief Financial Officer of Microsoft and treasurer of Microsoft, he came to Toronto in 2007 and took my wife and I out to dinner and said he was trying to put together a research group to work on economics and he would like me to be involved. And I said, “I don’t know anything about economics.” And he said, “That’s okay because nobody does and the whole system is about to collapse.” He said, “The balance sheets of all the big investment banks — it’s like they have cancer. They’re full of holes.” And I remember being very struck by this because this was before anybody was talking about this.

And so I started to meet with a group of people that he was pulling together to understand what was gonna happen and to understand if there was any way to save the situation. It was a very ambitious thing and, of course, we failed. But along the way I was motivated as a kind of public service to get interested in economics.

And what I found . . . economics, in a way, is very easy for a physicist to understand because it’s very mathematical. And the mathematical models that they use are very clean. They’re based on assumptions and hypotheses, and you can study them. And as I studied it I began to understand, some for myself and more from just reading around because the faults with the standard economic models, with the standard models of finance, are well known. They have been in the literature for decades and decades. So let me give some examples.

The standard model of economics is called the neoclassical model and it assumes that markets or systems where trading happens between consumers and firms and there’s certain simple models of how that goes on. And the ideas that these come to equilibrium. Equilibrium not in the physical sense but in special economic sense in which you reach a point at which the prices are fixed such that market forces fix the prices such that you maximize the happiness of the consumers and maximize the profits of the firms. And in so called equilibrium nobody can become happier or more profitable without somebody else becoming less happy or less profitable. And the ideology behind this — not behind the mathematics because mathematics doesn’t have an ideology — but behind the arguments that were made and still are made from this model is that markets don’t need regulation because they have these natural equilibria where everybody benefits to the maximum possible. And if you’re in equilibrium you can’t do better.

Now there’s a fault with this and it’s an obvious fault and it’s been known since the 1970s from some theorems proved by some economists including some of the founders of this field of mathematical economics, which is that there’s not one equilibrium, there are many equilibria. In fact, there’s a vast number of equilibria. And so which equilibria, even assuming that this is a decent model of the economy which is not clear, but even assuming it’s a good model, which equilibria you’re in depends on the past history, it depends on regulation, it depends on politics, it depends on taste, it depends on changing taste, changing preferences. And so history matters and what’s called path dependence matters.

This takes us outside the neoclassical model of economics but it doesn’t take us outside of economics because some wiser economist, for example, Brian Arthur had for years been developing models and theories of path dependent economy where the history does matter. People from the area of complex systems like Stu Kauffman, Prubac in developing models of markets where the history matters, where there’s not a single equilibrium, where there are many equilibria. And where change is paramount.

Another symptom of this is the idea that arbitrage isn’t, I mean, in these neoclassical models when you go to equilibrium, arbitrage is impossible. Arbitrage is making a profit from trading around a circle of goods or a circle of currencies without actually producing anything. And in equilibrium that’s supposed to be impossible but lots of firms and investment banks made fortunes off of currency trading, so why is that? It turns out because you’re never really at equilibrium… Remainder of transcript: http://bigthink.com/videos/how-bad-sc…

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9 Responses to “Physics Envy and Economic Theory”

I love economics and considered a PhD in economics…until I realized in my junior year that economics is closer to psychology and political science/history than “business or applied finance”. A pious investor is bettor off studying the history and state of market participants than forecasting or projecting or even worse, extrapolating with tons of yummy “all things being equal”.

He really needs to give that left hand a rest. But he is correct that economists carry a false sense of science into their work, and I don’t doubt that many of them truly believe they are akin to natural scientists, instead of just plain old run-of-the-mill social scientists.

Another pet peeve of mine is the media always touting professor so-and-so as a Nobel Prize in Economics winner, when there is no such thing. Shame on the Nobel Committee for even taking on this monstrosity of a prize in 1968. It just gave legitimacy to a bunch of blowhards for 45 years. You can’t put 20 of these “Nobel Laureates” of Economics in a room together and get them to even agree which way is north.

And before you try to tell me that Alfred Nobel had a prize in economics, check this out

Lee Smolin! One of my favorite physicist although I’ve never hear him speak – only read his works. In particular “The Trouble with Physics.”

Having just watched this there are many things that can be said. But just at the end I realized he was also arguing about a huge point in contemporary physics: does time exist or not? Or more particularly is it reversible? If it is reversible (as is implicit starting with Newton’s equations) time as it’s generally considered does not exist. Smolin would have the present minority position among physicists that the “arrow of time” (time is not reversible and moves only forwards) is real. The cooler, more hip position (among physicists that is) is that time is reversible; it’s just another dimension; and basically it doesn’t exist in the sense that the hoi polloi understand. I happen to agree with Smolin and believe that time is not reversible.

One of the principles of physics is the Uncertainty Principle. Does this principle also applies to economics and finance? I would propose that the more precise one attempts to measure some economic variable, the less certain the measurement of other economic variables become. To quote Yogi Berra: “Prediction is very hard, especially about the future”.

My undergraduate is in engineering and my graduate degree is in management/business so I’m only familiar with some physics and some economic concepts. But armed with that little knowledge I found the video pretty profound and feel I understood why Barry posted it. I had a “Wow” reaction. Society seems to contunually rely on these standard economics models to gauge how to run an economy. Or if not relying on them, then using them to justify economic political policies. It seemed to me that this educated “outsider” with a strong knowledge of mathematical modeling could easily identify and explain the flaws in the concept of market equilibrium. Even when studying the small amount of economics that I did in grad school, it felt contrived and arbitrary to me. I guess I feel somewhat vindicated when I see a video like this.

I would suggest that game theory is more appropriate than mathematical physics theory. Competition is more of a game where the enforced rules change during “play” and sometimes are not even known by all of the participants.

“A Brief Introduction to the Basics of Game Theory” by Matthew O. Jackson
Stanford University – Department of Economics; Santa Fe Institute; Canadian Institute for Advanced Research (CIFAR) December 5, 2011
“Abstract:
I provide a (very) brief introduction to game theory. I have developed these notes to provide quick access to some of the basics of game theory; mainly as an aid for students in courses in which I assumed familiarity with game theory but did not require it as a prerequisite.”
downloadable athttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=1968579

“Games are fundamentally different from decisions made in a neutral environment. To illustrate the point, think of the difference between the decisions of a lumberjack and those of a general. When the lumberjack decides how to chop wood, he does not expect the wood to fight back; his environment is neutral. But when the general tries to cut down the enemy’s army, he must anticipate and overcome resistance to his plans. Like the general, a game player must recognize his interaction with other intelligent and purposive people. His own choice must allow both for conflict and for possibilities for cooperation.

The essence of a game is the interdependence of player strategies. There are two distinct types of strategic interdependence: sequential and simultaneous. In the former the players move in sequence, each aware of the others’ previous actions. In the latter the players act at the same time, each ignorant of the others’ actions.”

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Ritholtz has been observing capital markets with a critical eye for 20 years. With a background in math & sciences and a law school degree, he is not your typical Wall St. persona. He left Law for Finance, working as a trader, researcher and strategist before graduating to asset managementRead More...

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